By Philip van Doorn
The stock market’s harsh reaction to Federal Reserve Chairman Jerome Powell’s speech last Friday should serve as a reminder: Difficult economic times are ahead, and what worked during the bull market can be a dark path for investors who want to keep making money.
A focus on strong, competitive businesses that can remain profitable and “press their advantages during tougher times” is favored by Matt Quinlan of the Franklin Equity Group, who is the lead manager of the Franklin Equity Income Fund /zigman2/quotes/207580268/realtime FEIFX -0.10% and a co-lead manager of the Franklin Rising Dividends Fund /zigman2/quotes/207167189/realtime FRDAX +0.13% .
He provided examples of such companies, while describing the two funds’ strategies.
Investments for an economy with higher rates
Over five years through 2021, the S&P 500 /zigman2/quotes/210599714/realtime SPX +0.69% returned 133% with dividends reinvested, while its information technology sector more than doubled that performance with a return of 303%. That was, by far, the best return for any sector, and it reflected the times — liquidity was high and investors were exuberant about sales growth, even for companies that weren’t consistently profitable.
But times have changed. Following Powell’s comments predicting “some pain to households and businesses” that will result from the central bank’s efforts to slow the economy and bring down inflation, stocks took a broad tumble on Aug. 26. The S&P 500 is now down 14% for 2022, while the tech sector is down 19.5% (again, with dividends reinvested).
In a note to clients on Aug. 28, Odeon Capital analyst Dick Bove called Powell’s remarks “superb,” because they emphasized the Fed’s commitment to stabilizing prices and made clear that the path toward achieving this goal “would not be short but it would be upsetting.”
We may be in for a years-long cycle of elevated interest rates. That means continuing pressure against stock prices, especially for companies that are heavily indebted or have low profit margins.
Also on Aug. 28, MarketWatch’s Mark Hulbert wrote the following in his discussion of bull- and bear-market signals:
When bull market sentiment is predominant, investors tend to focus on short-term technical factors such as momentum, trend following and chart patterns. Only near the end of bear markets do they begin to focus on long-term fundamentals.
In a bull market, some investors may become day traders, hoping to make quick profits as companies do whatever they can to push sales estimates higher.
What may be best for investors now, at what may be the early stage of a years-long process to quell inflation, is a long-term focus on quality. Quinlan named two stocks as examples — both are long-term holdings of the Franklin Rising Dividends Fund: PepsiCo Inc. /zigman2/quotes/208744353/composite PEP +0.75% and Microsoft Inc. /zigman2/quotes/207732364/composite MSFT +1.22% .
These companies may not inspire the imagination of the type of investor who got used to the good life of the liquidity-driven bull market, but look at the following summaries for each.
First, PepsiCo — the stock’s current dividend yield is 2.72%. That might seem relatively modest in an economy with 8% inflation, but it is much higher than the S&P 500’s weighted dividend yield of 1.63%, according to FactSet. Now consider how well this stock would have worked out if you had purchased it five years ago, based on data provided by FactSet:
You would have paid $115.84 a share for the stock on Aug. 29, 2017.
The annual dividend rate at that time was $3.22 a share, for a dividend yield of 2.78%.
The stock closed at $174.49 on Aug. 29, 2022, for a gain of 51%. If dividends had been reinvested, the five-year total return would have been 74%.